If you're new here, this blog will give you the tools to become financially independent in 5 years. The wiki page gives a good summary of the principles of the strategy. The key to success is to run your personal finances much like a business, thinking about assets and inventory and focusing on efficiency and value for money. Not just any business but a business that's flexible, agile, and adaptable. Conversely most consumers run their personal finances like an inflexible money-losing anti-business always in danger on losing their jobs to the next wave of downsizing.
Here's more than a hundred online journals from people, who are following the ERE strategy tailored to their particular situation (age, children, location, education, goals, ...). Increasing their savings from the usual 5-15% of their income to tens of thousands of dollars each year or typically 40-80% of their income, many accumulate six-figure net-worths within a few years.
Since everybody's situation is different (age, education, location, children, goals, ...) I suggest only spending a brief moment on this blog, which can be thought of as my personal journal, before delving into the forum journals and looking for the crowd's wisdom for your particular situation.

This was first posted in September 2008. Today the S&P500 trades at 1200 after having gone below 700 in 2009.

If you had bought index funds 10 years ago or 5 years ago, you would have gotten exactly nowhere(*). In October 1998, 10 years ago, the S&P 500 traded around 995. In September 2003, 5 years ago, the S&P 500 also traded around 995. In between those dates, the index generally traded higher. This means that if you have relied on dollar cost averaging over the past five or ten years like a herd of experts recommend, you would have lost money, because the current price is below the average price. Dollar cost averaging only works insofar the the final price is higher than the average price and not surprisingly, most proponents of dollar cost averaging finishes the the example on a high price, not a low price. In reality dollar cost averaging cuts both ways and it only works to average out volatility. So much for that theory.

(*) If you correct for inflation, you would have done worse. If you correct for the loss of international purchasing power by denominating the S&P 500 in Euro, even worse.

Contrary to popular opinion investing is not about picking the right stock or the right timing. Investing is a process. Some processes are rewarded and other processes are punished depending on whether they are compatible with the market. Index investing is essentially a buy and hold strategy of a few dozen large cap growth stocks (the rest of the index is just fluff). This works very well in trending markets because it avoids over-trading. In the long run this works very well. When markets are not trending and find themselves in a trading range, this does not work.

Trading ranges can last for many years. The current trading range era in the US has lasted a decade. In Japan it has lasted 20 years. In both countries cheap credit induced asset bubbles which were followed by government intervention that prolonged the stagnation. Index investors frequently say that they are in it for the long run. It is never quite clear how long that run is? A working career is typically 20 to 40 years long, so if that is a fair and realistic characterization of “the long run”, then 10 or 20 years is a fairly large amount of time to spend on a non-performing investment strategy. In other words, if you rely on the market to magically compound your savings for retirement, a 10 year stagnation corresponds to delaying retirement for 10 years.

The fact that an herd of experts recommend index investing (including Warren Buffet, whom I note does not use index investing for his own portfolio) as a sure-fire method to long term gains is a sure sign that it’s not going to work. There is no free lunch in investing, for who is going to give the money to who, when everyone takes the same side. Stocks, like real-estate, does not always go up and just because it has gone up for a long time does not mean it will continue to do so. Having a herd of people blindly buying at ever increasing prices only works to ensure a spectacular crash when the automatic buying gets out of step with the underlying fundamental reality.

In retrospect it was a good thing that social security was not privatized, at least not in the proposed form. Forcing everybody to hold the same fashionable and limited number of funds(*) would have resulted in another disaster of the kind we are currently seeing, only then there will be nothing to fall back on.

(*) It is the diversification of different strategies that keep the stock market aligned with reality. Herding around one strategy is what causes bubbles to appear.

What we are currently seeing are the indices selling off. Since a market index contains good stocks as well as bad stocks, it means that all stocks are dropping. The smart investors, however, buy up the good stocks and so the good stocks will overperform relative to the bad stocks. This transfers money from the bad companies to the good companies and from the index investors to selective investors.

During general routs, being selective works very well. During the past couple of weeks, my early retirement portfolio has outperformed the S&P500 between 0.5-2 percent per day! My portfolio relies mainly on dividend payments rather than liquidating a total return fund. Hence, my retirement is safe as long as the companies keep paying a dividend regardless of what the market thinks the stock is worth. During this crash, my only loser in my portfolio (which generally holds between 15 and 20 stocks) has been AIG. This has meant a drop in investment income of $88/year. This is certainly livable. On the other hand, with a 30% drop a $100000 S&P500 portfolio from which $4000 could be “safely” withdrawn, would now be worth $70000 and only $2800 could be withdrawn. This comprises a steep decline in “income”. Too steep for me!

The good news about the market rout is that the universe of stocks has now become a target rich environment of opportunities. Compared to last year, there are many more good stocks to choose from to build an income portfolio for an ERE style retirement much cheaper than last year. Furthermore, depressed prices leaves room for further appreciation. I hope to post a “model ERE portfolio” soon.

35 users responded in " The death of index investing "

Even an index fund posts some dividend/distributions, eh? Which mitigates, ever so slightly, the case you make about holders of the index going nowhere. (I haven’t held an index fund for 5 years, so I haven’t been tracking indexes.) They just don’t mean anything to your “selective investor”, unless one just keeps relative track for amusement.

Katsenelson’s book on range-bound markets speaks to your point about trading ranges.

I’d like to see OADSI completely privatized (no forced fund choices), i.e. tear up the socialist New Deal system and give the responsibility of providing for one’s later years back ton oneself. It’s amazing how trustworthy (whether financially or otherwise) an individual becomes when other individuals place trust in her/him. But short of the correct solution, I agree with you that the current system is better than index funds.

You’re doing quite well if you’ve only taken an $88/yr dividend rip, but what percentage of your annual dividend income is that? The BAC dividend cut put a 17% dent in my annual dividend income, but I’m concentrated in 5-7 stocks/eREITs/MLPs, so the risk was known and built into my plan (margin of income safety). I’m also in some muni bond CEFs — which have been hammered (on paper) with the rest of the market for capital — yet have given me a 4% raise in annual muni bond income, mitigating somewhat the dividend pain delivered by BAC.
Still, dividend ripping may have only just begun. Even quality companies can get caught up in a pull-into-the-turtle-shell environment.

Also agree with your assessment of the good news. Value investors, in quiet Schadenfreude, love this environment. I’m considering coming out of early retirement for the sole purpose of raising more capital for deployment into high-quality dividend payers (more of what I have). I wouldn’t mind a general stock market malaise for the next 10-15 yrs while I accumulate cash-yielding assets.

Index investing works for most people. It’s definitely better that daytrading 🙂 I don’t think it would be a good idea to have everyone actively trading stocks when they could be passively investing in a diversified portfolio.

There’s a lot of good quality dividend names out there which are trading at prices lower than what they have been in years. As for the $88 drop in income, seems to me that your dividend portfolio is not producing over $2000/year in dividend income..

LifeArtist said,

I just found your site last night and have been voraciously reading since. I admit to being one of the herd who has been heavily investing in index funds for 10-15 yr. So I have certainly lost money based on the 10+ year “trading range” of that index.

Nevertheless, the other advice on your blog about increasing saving rates still gives me hope of achieving “early” financial independence. Since my income is fairly high, an 8-10 yr plan is not unreasonable.

Frugal living, a high savings rate, and continued frugal living in retirement makes recovery from bad financial decisions early in life possible.

Jacob said,

My dividend income from what I consider my retirement portfolio is currently $3000/year. The $88 drop was thus about 3%. I hope to add a few hundred bucks more in income over the next week or so.
My main bank is WFC which recently raised its dividend (AIG did the same though just before they took at dip) My secondary bank is GE which just announced that they are not going to raise dividends next year (after having done so for the past 30+ years).
I also have some income from mutual funds, interest from savings, and some non paying stocks which I am not liquidating due to capital gains taxes, etc.

Kevin said,

Do you see all passively managed funds as flawed, or just the ones that track broad market-weighted indices e.g. S&P500? There are index funds that track more esoteric indices, for example the Dividend Achievers Index, whose definition of ‘good company’ seems similar to yours. I’m curious if you would support buying funds such as those as an alternative to picking a handful of dividend-paying value stocks manually.

“Dollar cost averaging only works insofar the the final price is higher than the average price and not surprisingly, most proponents of dollar cost averaging finishes the the example on a high price, not a low price. In reality dollar cost averaging cuts both ways and it only works to average out volatility. So much for that theory.”

I think you’re missing the whole point of dollar cost averaging – which is to mitigate risk. What if the index investor bought all their shares at the top of the market in 2001 or whenever – they’d be down a lot more than someone who, through dollar cost averaging, bought the same # of shares.

Index investing and dollar cost averaging are not equal. In fact, I would guess you are dollar cost averaging if you are reinvesting your dividends.

Reinvesting dividends isn’t necessarily cost averaging. Some people arrange to automatically reinvest dividends in the security that yielded the dividend, immediately when it is posted (or within several days) — that is cost averaging. Other people arrange to take all their dividends in cash, and selectively reinvest those dividends in the most undervalued / highest-yielding positions in their portfolio — that is conducive to value averaging.

I find it amusing that some posters think you are advocating a trading strategy, like there is only index or trading options.

Personally, I don’t like to limit myself. If stocks look good for 5 years, I will hold. If they look terrible, like they did last fall, I will sell and wait for a good entry point. Why restrict yourself to one strategy, when there are numerous ways to make money. Everything works at some point. Buffett makes money no matter what happens. Why? Because, his strategy changes. He wasn’t buying 10% preferred with options in the 70’s, but he is now. Why? Because the man knows a good deal, no matter how it is structured. Look for the undervalued and buy. Is there any other way?

Indexing works for most people because very few folks out there are good at predicting major trends. In fact most people are excited when indexes reach new highs and get sick when indexes plunge to 5 year lows. The problem is not with indexes but with one’s asset allocation.

Jacob,

Dividend stocks are pretty cheap right now. I was able to snap up some good names at what I believe to be attractive prices. I also learned about some dividend increases from UTX, KMR, TPP, RPM which is good news for me.

Jacob said,

@Kevin – passively managed is an oxymoron 🙂 Even the SP500 and the DJIA change their components from time to time. I think the main problem is in doing what everybody else does (owning things that everybody else owns) and specifically trying to be average. I think the main virtue of indexes is that they instill a certain discipline and avoids too much turnover. In fact I’d bet that a large part of the reason that so many actively managed funds underperform is due to their high turnover.

@Kevin M – Dollar cost averaging reduces volatility. Volatility is often thought of as risk (especially by the efficient market theorists). Dollar cost averaging does not reduce downside risk which is what value investing tries to do. If you bought in 2001, you would have had a lot of downside risk. If you bought in 2003 you would have had less. I agree that they are not equal, but index investing and DCA are often done by the same people. DCA in particular is popular by the majority of people (easily associated with automatic withdrawals, Wall Street job security – hence very much promoted). I do not automatically reinvest dividends. My money generally flows to whatever is currently most undervalued. I just bought some REITs (HRP and BEE). Another reason that I don’t automatically reinvest dividends is that cost basis calculations become a nightmare (I won’t rely on programs to do that).

@Chad – Indeed, the drive for “eternal strategies” is strong. Index investing has not worked since the major 1982-2001 trend. Value investing does not always work, etc.

@DGI – I’m not sure I understand the choice of RPM. What’s the motivation there?

@DGI and Steve Austin – I do not have any experience in buying MLPs or LPs. Don’t they come loaded with wicked tax filling requirements? Any good ways to get started on it. I would dearly love to own infrastructure.

People should be aware that the benefits of dollar-cost averaging are fictitious. If you break up your lifetime investments into, say, half a dozen batches and invest half a dozen times spread out over your career, you will have almost identical risk/return characteristics compared with someone who did monthly dollar-cost averaging over the same time period.

Jacob –
You’re correct about MLPs and LPs coming with “wicked” tax complications. You’re looking at filing Schedule E, as well as at-risk limitations and passive activity rules if there are losses. I’m sure there are good ones out there, but none of my clients seem to get much out of them other than a much bigger tax preparation fee.

It’s funny how you happened to pick a period which shows the worst possible result. Not very valid in my opinion.

Kevin said,

That’s what I figured. To me “index investing” means buying and holding mutual funds that use a static, mathematically-defined trading strategy, and as a result have low expenses, low turnover, and low exposure to human error. The most common strategy, and the one you’re arguing against, is to buy one fund tracking the S&P500 or total market, but in my mind “index investing” encompasses other strategies as well.

That being said I’m skeptical that there are enough people using this strategy to influence the market significantly. It certainly dominates the blog world, but anecdotally every stock investor I’ve talked to either buys traditional actively managed funds or churns individual stocks haphazardly. I’m curious if anyone has figures on the percentage of the market owned by index funds.

@ABC of investing – Counting in the dividends of market funds is almost irrelevant. They’re 1-2% (higher now) or lower than inflation. If you assume no inflation, you’re looking at doubling times that span 1-2 generations.

@kevin – As far as I know, it is mostly big institutions that does most of the buying and selling.

MLP’s are a little bit more challenging tax wise. There are funds that hold MLP’s and pay out nice distributions as cap gains or extra shares.
Instead of holding KMP the MLP, you could hold KMR the mgmt company behind the mlp that owns about 1/3 of it. It pays you in extra shares – thus essentially reinvesting the dividends for you..

Index investing and dollar cost averaging are both very good ways to get AVERAGE returns over the LONG TERM. They are simple and have lower risk and volatility. If you are in the market for long term and wish to mitigate risks of high loss then Index investing and DCA are both good choices.

Index investing is simple and easy. It has high diversity and gives average rates of return for the market. Sure you can feasibly do much better if you pick the right stocks, but you can also do horribly if you pick the wrong stocks. If you don’t like index investing then what is your preferred alternative and WHY?

I really don’t see ANY reason dollar cost averaging is a bad idea. It averages out the ups and downs in a volatile market. DCA just keeps you from having bad luck or avoiding the trap of thinking you can time the market. If you don’t like DCA then whats your alternative solution and WHY is it better? Steve mentioned Value averaging above which is one reasonably good alternative.

@ABC – I just picked the present method. There are people that fail “in the long run”. What we see right now is a transfer of wealth from those who just retired to Generation Y.

Jacob said,

@Jim – So the question is one of eliminating “luck” in terms of stocks and time. Index investing aims to do both statistically by indexing and DCAing respectively.

You can get most of the random chance out of the system by owning 15-20 stocks. You don’t need to own 500.

It is a statistical fact that low P/B, high P/D, or low P/E stocks do better than average stocks. It is also a statistical fact that when the market has the opposite values of those, it will tend to do poorly. This is not timing, rather it’s simply avoiding batting when the odds are bad.

I’m not sure index funds are dead. There are lots of active funds that have lost even more or went out of business. The problem isn’t index funds (you could have purchased a gold fund and it would have gone up a lot), but one of asset allocation. Risk was sold too cheaply for a long time in the US and Europe. Investors took on too much risk for too little reward and we are now only playing catchup. It will turn around again one day.

btbw2380 said,

Since most of a portfolio’s return is predicated on the mix of asset types, indexes are the optimal approach towards capturing that return as they are most likely to stay true to their respective slice of the pie. The S&P 500 is just one small part of the index world. Don’t see anyone referencing time periods where dividend stocks, with dividends reinvested, did nothing for a decade. Please don’t say at least you’re collecting the dividend as it’s not all that difficult to realize capital gains on appreciated funds when cash is needed (and if tax rates on dividends go back to one’s marginal tax rate, capital gains have a tax advantage as well). Buffet advocates indexes for individuals because of the fact that few can successfully pick stocks and/or identify trends to time the markets. And yes Jacob, Buffet is not an indexer but if anyone here has a fraction of his talents, I don’t think they’re all that interested in the lifestyle of ERE.

fred said,

Do you understand that by trying to beat the market average over the short to medium term, you are playing against professionals who are better informed than you and have lower trading costs than you? The only possible advantage you have is that you are so small that none of your trades will move the market, but even this advantage is disappearing due to high-frequency trading.

All a hedge or mutual fund manager has to do is read your “brilliant” strategy as described on this website and duplicate it and voila! He beats the market averages, investors flock to the fund, and he gets a huge bonus. The world of investing has no barriers to entry and is extremely competitive. “Brilliant” strategies don’t last for long, especially when they are advertised.

Beating the market over the long-run is a different story, because fund managers can’t just sit around in bonds for 10 years or so when the market is overpriced. They’d be fired or lose their clients long before the 10 years was up. Individuals can, and the smarter individuals did back in 1999. But the US market cap alone is $15 trillion and there simply aren’t enough of such long-term oriented individuals to push they market down.

In other words, the intelligent thing to do is buy index funds when they are fairly priced (because the market IS relative-value efficient in the short to medium run due to extreme competition) and switch into bonds or cash when these index funds get overpriced (due to periodic irrational exuberance by the masses).

In the long run, the average investor must get the average return, and this average return must equal the marginal cost of capital, which is the return necessary to induce savers to invest one more dollar into the stock market (via IPOs and other primary sales, since the secondary market does not involve new investment), which is probably about 5%/year after inflation (3% risk premium over the 2%/year from long-term TIPS). For you to get more than 5%/year, someone else has to get less. Who are these dummies? Why aren’t the hedge funds picking them off before you?

” In reality dollar cost averaging cuts both ways and it only works to average out volatility.”

So well put Jacob. I’ve always been suspicious of this strategy for just this reason. It’s only the long term bull runs that give this and other buy-and-hold schemes their validity. But then nearly all investment strategies work when the market rises for years on end. Guru’s and investment “geniuses” spring up along the way.

Jacob, you’re idea of investing in dividend stocks is the way of the wealthy. They don’t buy fads or funds, they buy cash flows–that’s where the long term money is (including Buffet). It stacks the deck in your favor no matter what the market is doing.

As to index funds–and most funds in general–they have their proper place. Like when the market tanks as it did in 87, 00-02 and 07-09. When the selling stops, they can provide an easy way to get back on the elevator for the ride up and to do it without any management or stock picking needed.

I think the limitation with all funds and most long term investment strategies is that they oversimplify investing. They try to make it out to be a fire-and-forget process, which it can’t be. Anything that’s that easy, that guaranteed, carries no risk, and therefore no corresponding greater reward.

The attraction of index funds, dollar cost averaging, etc, is that they make for neat marketing content because they appeal to the unsophisiticated (read: non-investment savvy) masses who want to get rich without doing anything. BTW, if anyone finds a way to do this, email me (PLEASE!).

George the original one said,

> The attraction of index funds, dollar cost
> averaging, etc, is that they make for neat
> marketing content because they appeal to the
> unsophisiticated (read: non-investment savvy)
> masses who want to get rich without doing
> anything.

The easiest first step for the masses is to actually SAVE money. ERE strategy is a winner here and it doesn’t matter whether you use index funds or not.

I’m not a fan of index funds because:

1) they buy & hold stocks that aren’t worth owning simply because they’re in the index

Example: Expensive BP floating rig catches fire… not a big deal in the industry until it tips over and sinks. Once that happens, you KNOW BP stock is going down, so why not sell it ASAP? Nope, the index fund has to continue holding it because it’s in the index.

2) they have to deal with investors hopping in and out of the fund, thus setting up random buy & sell moments

Example: In a widespread liquidity or unemployment crisis like we recently had, people are getting out of the index fund not only because they’re fearful, but also because they may simply need money. Which creates a positive feedback loop on the fearful part because the investment is losing value.

Jacob said,

@fred – Essentially what you said, but also for single stocks. Sometimes indexes get overpriced simply because they’re driven by about a dozen of several overpriced stocks.

Professionals may be better informed, but individuals have a size advantage in small cap. They can buy and sell without moving the price. Someone needing to invest $10 mil don’t have that advantage. Professionals also have a risk-bias because they depend on their salary which is determined by quarter-like performance relative to other money managers rather than long-term performance. This leads to a certain herd-like behavior. Better informed doesn’t necessarily mean being right.

The problem is that for most people it is hard to save that 75 %. Just like R. Kyosaki said: “most people prefer to be in a comfort zone and stay like that all their lives, then make some effort for a while and then be free do anything”.

As a PhD researcher, you should know that this blog entry and your other investing entries are rather .. what’s the word .. weaksauce. You point to “S&P did XX.X%% over XYZ time period” and then counter with “but if you followed this strategy”. Except you don’t give the strategy specifics, what the returns are, research on how your strategy might have done in the past, follow-up with how it’s doing since then, etc. Basically, you’re comparing apples (specific index, time range, data) versus oranges (nebulous investing ideas) — and everybody replying to your entries always pile on on either the apples side or the oranges side but never realizes they’re different fruit.

Now detailed investing talk would not make sense on your blog. Alternative living, human footprint on the world, DIY projects, expenses, psychology — that all goes with your ERE/global resources philosophy. Sandwiching technical talk about about stocks and bonds just does not fit. Hence, I’d say it’s better not to even talk about investing other than in the most general terms.

ranch111 said,

I index invest. I don’t hold single stocks (like AIG, you can lose the farm). My investment strategy involves the total market with strategic allocation, not just the S&P and I receive dividends. I’m lazy. I have better things to do than actively trade stocks, worry about whether a company will crash, or having to switch out stocks because of performance or a cut or loss of dividend. Index funds take care of all of that for me. I reallocate when needed. I’m not going to ERE, so I don’t care about creating income now. I think if you want to follow Jacob’s advice and ERE, then his strategy makes sense, but for the masses, index investing suffices.

Jacob:
You picked a 10 year timeframe for the index/averaging strategy, but given that many ‘mainstream’ people aim to retire in 30-40 years, maybe the window is wrong. Is there any period over which this strategy is bad for a 30 year period? I agree that someone looking at ERE in 5-10 years shouldn’t take this route necessarily (unless they believe the whole market is undervalued, and don’t want to try and cherry pick the most undervalued stocks/funds).

Given the expanded timeframe in the last 30 years the S&P500 went from about 100 to 1200 now. The worst time I see in the DJIA from 1900 is 30 years from 1902 to 1932 (with the stock market crash and the Great Depression), which actually results in a loss.

Devans0 said,

I have used Total market allocation and indexing to build my nest for the last two years. For me, it is working. In a bad market, I was able continue to steel myself to save and invest, knowing that I was buying at good prices.
I am searching for a good investment weighting strategy to give some leverage to sell more when the market is high, and be ready for the next crash. Right now, it is seat of my pants winging it. My thinking is that if periodic reallocation forces me to sell high and buy cheaply, a doubling of that reallocation should be even better. I am currently overweight in small cap funds both in the USA and global markets figuring that as we recover from our current recession, these will be the early winners.
I tried following trend investing using mutual funds and had some very good years, but would lose my butt in down markets. I became a herd investor because of it and quit. Costs were too high and systemic mutual fund rules and whiplashes of fear and greed cause even the best managers to be forced to sell low and buy high.

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